DP8143 Politics and Monetary Policy

Author(s): Michael Ehrmann, Marcel Fratzscher
Publication Date: December 2010
Keyword(s): delegation, European Central Bank, interest rates, monetary policy, time inconsistency
JEL(s): D72, D73, E43, E52, E58
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=8143

How and why do politicians? preferences about monetary policy differ from the interest rates set by independent central banks? Looking at the European Central Bank, the paper shows that politicians, on average, favor significantly lower interest rates. Three factors explain the different preferences. First, politicians put relatively less weight on inflation (and more on output) in their preferred monetary policy reaction function. Second, politicians? preferences are affected by political economy motives. Third, different preferences are also, and largely, due to different constituencies, as politicians primarily focus on national economic objectives rather than the euro area as a whole.